Is the Fed Losing The War Against Inflation?
Last week we learned that U.S. inflation clocked 8.2% in September 2022, signaling that consumer prices rose more than expected, keeping inflation stubbornly near its highest level in decades. With the cost of living in the US showing stickiness to the upside, what can we expect from the Federal Reserve to address this nagging issue and how soon will things turn around?
Higher prices for just about everything, rent, healthcare, food & groceries are just some examples of everyday commodities and services that have directly affected consumer purchasing power. For context, U.S. retail sales were unchanged month over month as at September 2022 compared to August despite falling gas prices, but rose by 8.2% year over year which is exactly in line with the inflation reading for the period. This suggests that more of consumers’ money is being spent on a similar number of goods.
Given this backdrop, the U.S. Federal Reserve is leaning on the most powerful weapon in its arsenal to ensure price stability: interest rates. The Fed has hiked interest rates five (5) consecutive times since the beginning of 2022 in incrementally larger amounts to contain inflation. Considering the US inflation target of 2% versus the current headline level of 8.2% and with the less volatile and more stubborn core inflation reading at 6.6%, the FED has some way to go.
Core prices, which exclude volatile food and energy categories and are widely seen as a more reliable barometer of underlying inflation, hitting at 6.6% annually in September – the highest since 1982. Core inflation is typically more stubborn and usually gives a better representation of where inflation is likely to hover into 2023. For perspective, the International Monetary Fund’s (IMF's) expectation of US inflation stands at 7.1% in 2022, and at 3.6% for 2023, which is still almost twice the FED’s target level of 2%. Also, given that core inflation, which is sticky, is 6.6% as at September 2022, we believe it is not likely to fall to as low as a 2% level in 12 months, which is what would happen for U.S. headline inflation to align with the IMF’s estimate of 3.5% for 2023.
Importantly, FED hikes typically result in lower inflation and an uptick in unemployment but that hasn’t been case so far and because of this, The Fed is forced to maintain its hawkish stance and extend the current hiking cycle into 2023 in an effort to get inflation under control, slowing consumer demand and softening the labour market in the process.
As we anticipate the next Fed meeting on November 2nd, 2022, and a baseline expectation of another 75-basis point hike, there are growing concerns of a recession, not only in the U.S. but worldwide in 2023. Fed Chairman Jerome Powell recently acknowledged that the broad impact of higher borrowing costs will bring “some pain to households and businesses”, from this we can expect job losses, or labour market softening and a possible recession. Of note, the true effects of the rate hikes typically lag by 6 months before taking effect on the real economy. Therefore, October’s real economy is driven by April’s policy rate.
Oil prices have fallen to roughly $80 per barrel from more than $120 in early June amid growing fears about a recession. To address this, the Organization of Petroleum Exporting Countries (OPEC) cut oil output by 2 million barrels per day (bpd) in October, boosting crude oil futures. This is also expected to increase the prices at the pumps, also contributing to the inflationary concerns. The decision was made based on the uncertainty that surrounds the global economic and oil market outlook for Q4 2022 going into 2023. The higher oil prices could sustain above average inflation for countries buying their oil using US dollars. OPEC’s next meeting is on December 4, 2022.
Where do markets go from here and how to position an investment portfolio?
We can expect more robust tightening ahead given that inflation is here to stay. The IMF is expecting the global inflation to continue to persist for 2022 to 8.8% but decline to 6.5% by the end of 2023 and 4.1% by 2024, which is still above the target of 2%. Global economic activity continues to experience broad-based and sharper than expected slowdown, with inflation peaking at historic levels. The cost-of-living crisis, tightening financial conditions in most regions with the ongoing invasion of Russian and Ukrainian territories and the lingering Covid- 19 pandemic all weighing heavily on the outlook.
Investing in bonds that have shorter maturities should reduce portfolio downside, as longer bonds tend to fall more when interest rates rise. Given that interest rates are on the rise, investors can capture more yield than they would have in 2020 or2021 without buying weaker credits. Higher yields could also increase defaults for weaker credits more so junk bonds, thus, buying on fundamentals should benefit investors.
Equities are likely to see more volatility as the labour market loses steam and as hikes continue. Technology has more downside risk, with outperformers expected to include energy and consumer staples on a relative basis. The post-COVID Christmas trade continues to be attractive for opportunistic investors who wish to buy U.S. stocks like
Mastercard, Apple, Dollar Tree and Coca-Cola that are positioned to significantly benefit from holiday spending in terms of earnings.